Picture your Future. Save for it by earning 1.5% on a 1-year Term Deposit Account! Learn more.

Morningstar Insights: Want to Invest Successfully? Quit Trying to Make Sense of It

Jeffrey Ptak, CFA, Chief ratings officer for Morningstar Research Services LLC, speaks about how the Intuition usually fails us when it comes to investing.

About a year ago, Russia invaded Ukraine, an appalling act rightly condemned by the world. In the immediate aftermath, experts weighed the economic impacts, with many projecting sharply higher commodity prices. The prediction made sense: A Russian oil embargo would crimp supply, sending prices higher, or so the thinking held.

What happened? Brent crude-oil futures prices spiked at first, rising from around $94 per barrel preinvasion to nearly $130 a few weeks later. But by last summer Brent was back to its preinvasion price and has fallen further since. An investor who bought Brent futures on the eve of the invasion and held onto them now has lost nearly 9%. Whereas an investor who bought global industrial and basic materials stocks—sectors then thought to be at greater risk of higher commodity input prices—made money.

What Makes Sense?

As this example underscores, markets are unpredictable, especially over shorter spans. Yet you wouldn’t know that from how many of us approach investing, where we define “good” investments as those that made intuitive sense to us at the time—that is, the commodities that would rally after the Ukraine invasion because the supply shortfall would yield a scarcity premium. And conversely, we dismiss investments that don’t square with whatever cause-and-effect framework we’re applying.

To illustrate, consider a few common scenarios, where we can hurt ourselves by going with what made sense to us at the time, instead of what might really have been sensible under the circumstances.

The Case Against Intuition

Why can’t we trust our intuition to evaluate an investment’s merit? In this piece, I’ll lay out four reasons.

Reason #1: We’re desperate to make sense of things at times when we’re uncertain or feeling frazzled

The main reason we try to make sense of our investments is to regain control of an uncertain or stressful situation. When stocks are in free fall and headlines are blaring alarms, it can be hard to imagine what could spark a rally. Yet we can come up with explanations galore for why the selling will continue unabated. In that scenario, with our emotions revved up, we’re likelier to seek safety in cash and bonds, as they fit the narrative: The selling will continue, so take shelter.

Unfortunately, we tend to be at our worst as investors at times like these when emotions are running high. When we cling to intuition, subjecting our investments to a common-sense test, we might manage to subdue our emotions for a time, but we do so at enormous cost to our investment success.

To illustrate, consider the following chart, which shows U.S. large-cap stocks’ returns in the 36 months that immediately followed a three-year period in which they lost money. (Since 1925, there have been 176 rolling three-year periods in which U.S. large-cap stocks have posted a negative return.)

These stocks suffered two consecutive losing 36-month periods only 19 times. What’s more, they usually rebounded strongly, earning about 14.2% per year, on average, in the three years following a losing 36-month period. That was especially true of the 25 worst three-year periods for U.S. large-cap stocks. In the three years that followed these episodes—which included the Great Depression, the global financial crisis, and the bursting of the internet bubble—stocks rose by roughly 22% per year, on average, more than double the average return in all other 36-month periods over the past century.

In all 176 of these instances, investors would have tried to make sense of their stock allocations, asking themselves why, amid all the pessimism, losses wouldn’t beget losses in the years ahead. And in nearly every instance intuition would have failed them, with stocks roaring back.

Reason 2: We seek reassurance from others who share our view

It’s not just that we tend to try to apply intuition at inopportune times; it’s also that we form our views of what does, and doesn’t, make sense based on what we see and hear from others at those times.

Many of us would like to think that we’re contrarians, boldly going our own way, consensus be damned. We’re not, though. We usually seek out confirming views, with the market itself serving as our proxy for the consensus view at a given moment.

In that way, using intuition to assess an investment is a bit like chasing one’s own tail. We gauge the investment’s merits based on how it’s performed or the way we see other investors responding to it. Then we construct a narrative that explains the mental picture we’ve formed, in which a “good” investment is one that’s risen and a “bad” investment one that’s fallen. When markets inevitably move in ways that defy our predictions, we recast “good” and “bad,” repeating the cycle.

Reason 3: We fail to consider what’s already priced in

When you take the first two reasons together—our tendency to apply intuition at times when we’re feeling frazzled and our need for reassurance from others at those times—we blind ourselves to another reality: Markets price in a potential scenario well before we can act on it.

Take the example of a looming recession. Typically, by the time data begins to show signs of a cooling economy, the market has already begun its pullback, anticipating worsening profits and other fundamental deterioration. Yet, we typically aren’t going to act on the first sign of trouble such as a surprisingly bad nonfarm payroll number. Instead, we’ll wait for consensus to form, which usually doesn’t happen until more data arrives, by which time the market has moved on to the next matter.

This works in reverse, too, a great example being “thematic” stocks. These are typically businesses that boast breakthrough technology and know-how, or which operate in fields sitting at the cutting edge. Many of us find stories like these irresistible. Unfortunately, by the time we conclude these stocks can’t miss, the market has beaten us to it, pushing valuations to nosebleed levels and limiting future returns.

That’s apparent when we compare global thematic funds returns’ to the flows these funds have received from investors over time. The pattern is unmistakable: Returns impress, flows follow, only for performance to dramatically fall off, burning investors who had chased returns into these funds in the first place.

Reason 4: We fool ourselves

There’s a wealth of research that finds we are not reliable narrators of our own investing journeys. We have a propensity to repress painful memories, such as costly mistakes, while we exaggerate whatever successes we’ve achieved along the way, blowing them out of proportion.

The truth is that successful long-term investing demands resolve and a healthy constitution for uncertainty. Much of the time we’re not going to be able to explain the market’s gyrations. Those of us who are willing to surrender to that unknowability stand to earn higher returns, which is the market’s way of compensating us for the bewilderment we experience along the way.

But when we make intuition an acid test for investments, we presume otherwise. We see cause and effect where there is none; we chalk up a favorable result to factors that, in reality, were incidental at best to the outcome; and we rationalize our failures, attributing them to uncontrollable forces or actors (like the Federal Reserve keeping rates extraordinarily low for longer) in ways that avoid a true accounting.


Morningstar Disclaimers:

The opinions, information, data, and analyses presented herein do not constitute investment advice; are provided as of the date written; and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this document. Except as otherwise required by law, Morningstar, Inc or its subsidiaries shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. It is important to note that investments in securities involve risk, including as a result of market and general economic conditions, and will not always be profitable. Indexes are unmanaged and not available for direct investment.

This commentary may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

The Report and its contents are not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Morningstar or its subsidiaries or affiliates to any registration or licensing requirements in such jurisdiction.


MeDirect Disclaimers:

This information has been accurately reproduced, as received from Morningstar, Inc. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. Any decision to invest should always be based upon the details contained in the Prospectus and Key Information Document (KID), which may be obtained from MeDirect Bank (Malta) plc.

Join MeDirect today to access the tools you need to put your money to work on your own terms.

Latest news articles

Playing demographic divergence now
All News

BlackRock Commentary: Playing demographic divergence now

The working-age populations in developed markets (DMs) are dwindling, contrasting with the growth observed in emerging markets (EMs). This trend adversely affects economic growth in DMs while bolstering growth prospects in EMs—a divergence that, according to BlackRock, is widely evident in asset valuations.

Hacktivism is hacking but for a political or social cause, rather than just for money. This article explores the threats from hacktivists and the ways to defend yourself and your organisation.
All News

As elections loom, beware of hacktivism

Hacktivism is hacking but for a political or social cause, rather than just for money. This article explores the threats from hacktivists and the ways to defend yourself and your organisation.

When building an investment portfolio, make sure to keep track of the fees and expenses you are being charged to trade or hold specific assets. This will help you ensure you enjoy the best possible returns from your money.
All News

Investing: Understanding Fees and Expenses

When building an investment portfolio, make sure to keep track of the fees and expenses you are being charged to trade or hold specific assets. This will help you ensure you enjoy the best possible returns from your money.

Experience better Banking

The sooner you start managing your money, your way, using the best-in-class tools, the sooner you’ll see results. 


Sign up and open your account for free, within minutes.

MeDirect_Multi-Devices-cards

Login

We strive to ensure a streamlined account opening process, via a structured and clear set of requirements and personalised assistance during the initial communication stages. If you are interested in opening a corporate account with MeDirect, please complete an Account Opening Information Questionnaire and send it to corporate@medirect.com.mt.

For a comprehensive list of documentation required to open a corporate account please contact us by email at corporate@medirect.com.mt or by phone on (+356) 2557 4444.